Private Equity Exposed: A Lawsuit Blows the Lid Off Shady Deals

October 12, 2012

One of the salutary side effects of the Mitt Romney presidential bid is that it has shed light on one of the most secretive yet influential parts of the financial services industry: the major buyout firms. Thanks to motions filed by the New York Times, a federal judge in Boston released court filings this week that had previously been under seal in a class action, anti-trust lawsuit -- Dahl v. Bain Capital Partners -- against the eleven biggest and most blue-chip names in the private-equity industry, including Blackstone, Carlyle, Goldman, and TPG. The plaintiffs contend that they lost billions as shareholders in companies that were sold at lower prices than they would have otherwise fetched in the 2003 to 2007 period due to buyer collusion through a system they called “club deals.”

No wonder the defendants had been keen to keep the case under wraps. The 221-page complaint goes through 27 transactions, and with each, presents not only persuasive economic analysis, but more important, damning e-mails showing how the heads of each of the firms were involved in submitting sham bids, sharing information about their offers, working with management of the target companies to restrict the sales process, enforcing elaborate systems of quid pro quos (for instance, not submitting a bid with the expectation of being cut in on that deal or future deals), and other forms of market manipulation. The messages make clear that the intent was to reduce competition and buy the companies on the cheap. For instance, on the sale of Toys R’ Us,

KKR representatives admitted that KKR decided to partner with Bain and Vornado due in part to its "desire to effectively eliminate a competitor from the auction process."…. Richard Friedman, head of merchant banking and PIA at Goldman Sachs, acknowledged in an email the belief that "the competing bidders ha[d] colluded and ganged up.”

It’s obvious that reducing the number of bidders and containing the competition among them would lower prices. I ran a mergers and acquisitions department in the 1980s, shortly after auctions became the preferred way for selling companies. The rule of thumb was that getting an additional bidder increased the sales price by 10 percent. The complaint includes economic analyses that show that these mega funds got better prices on average on these deals than on the ones where they duked it out.

Now after ordinary consumers have been on the wrong end of bank bailouts, foreclosure fraud, credit card tricks and traps, and debt collectors from hell, this scheme might seem like a fight between different types of investors and hence of limited real world import. That view could not be more wrong. Private equity firms concentrate enormous financial power in comparatively few hands. Their $2 trillion of assets under management, which they augment with a typical $3 of borrowed money for every $1 of their investors’ money that they put down, translates into $8 trillion of buying power. Compare that to the roughly $16 trillion value of the U.S. stock markets at year end 2011. More people in the U.S. work for companies owned by PE funds than belong to unions. More than half the corporate debt in the U.S. is rated junk, and the high leverage used by PE firms in their deals is far and away the biggest culprit. It’s a virtual certainty you are supporting the private equity industry. Public pension funds, whose monies come from state and local tax dollars, are one of the biggest investors in LBO funds, particularly the mega funds like KKR and Blackstone.

LBO firms fetishize secrecy and use their power to maintain it. Given that governments, both public pension funds and sovereign wealth funds, are important investors in these vehicles, their contracts with these firms are of public interest. Yet PE firm threats to turn away government investors in states where their agreements might be exposed through state Freedom of Information Act requests have led to extreme measures such as the passage of state laws to keep executed private equity from being classified as public records, unlike every other contract for goods and services. This double standard pervades the funds’ dealings with their investors. For instance, the extensive communications among private equity firms presented in Dahl v. Bain look to a layperson like clear-cut anti-trust violations. Yet the PE firms try to cow their investors by claiming that communicating with each other could violate anti-trust laws!

It’s time to pull the veil off this industry. Public interest requires much greater transparency. Congress should call hearings and require that the heads of these private equity firms testify under oath. And any settlement in this case should be a matter of pubic record.